What are the disadvantages of a Roth IRA?
Roth IRAs are an outstanding investing tool, but there are some disadvantages like tax deductibility, contribution limits, income restrictions, and withdrawal limitations that should be considered before opening a Roth IRA.
I really like Roth IRAs.
What’s not to love about the tax-arbitrage and tax-diversification options they provide when coupled with Traditional IRAs?
And, considering income taxes are about as low as they’ve been in a long, long time, the opportunity to lock in your tax liability before investing assets is a nice perk too.
Maybe I can name my next dog “Roth.”
Speaking of dogs, even though they’re nearly perfect, they do have some undesirable qualities.
Roth’s aren’t perfect either.
Let’s look at some of the disadvantages of Roth IRAs, some ways to overcome them, and alternatives you might consider for your own retirement saving.
Disadvantage #1: No up-front tax deduction
Alternatives: Traditional IRA, Traditional 401(k), HSA
How to Overcome: You can’t. There are no deductions for Roth contributions.
Since you’re reading an article about Roth IRAs you’ve probably had to wrestle with the age-old conundrum (since 1998 anyway) of investing in Roth vs Traditional IRAs.
Traditional IRA and 401(k) contributions offer the lovely benefit of deductibility from one’s taxable income.
This means when you save $5,000 in a Traditional account, you get $5,000 in the account that hasn’t been burdened by taxes at all. So, all of the money you contribute gets to grow unhindered by taxes until you begin making withdrawals in retirement.
Roth accounts, however, do not permit a tax deduction for contributions. Instead, Roth withdrawals are made completely tax free.
So, the same $5,000 you put in a Roth was actually closer to $5,500 or $6,000 or more before income taxes were paid. Sure, you get to take it out tax free, but the initial cost of your contribution was higher.
As a result, if you have a high income, you might favor a Traditional IRA over a Roth to take advantage of the tax deduction now.
Disadvantage #2: Contributions and Withdrawals Come From the Top
Alternatives: Traditional IRA, Traditional 401(k), HSA
How to Overcome: Again, you can’t unless the IRS overhauls how AGI is calculated.
I don’t see this disadvantage pointed out very often when people discuss or write about the downsides of Roth IRAs, which is a shame because it is potentially very important.
When you calculate your adjusted gross income (AGI) on IRS form 1040, you start by listing earned income, adding interest and dividend income, IRA distributions, pensions and annuities, and Social Security benefits.
The sum of all of these, minus some deductions, is used to calculate your taxable income and eventually your marginal income tax bracket.
If you were to make a contribution to a Traditional IRA your taxable income would be reduced by the amount of your contribution and the money you save would be the taxable amount of that deduction.
Since it comes off the top of the total income amount, the deduction comes from the income that is taxed in your highest or marginal tax bracket. (For more about progressive taxes read this post.)
So, if you made a $5,000 contribution and your marginal tax bracket was 22%, the deduction would be worth $1,100 in avoided taxes.
Furthermore, when you make withdrawals (probably at retirement) you aren’t as likely to have any or as much earned income.
This means any income you’ve pulled from your IRA will be counted earlier in your adjusted gross income calculation and, therefore, taxed in a lower bracket.
For example, let’s say you’re totally retired and pull $5,000 from an IRA.
The first $5,000 of income is only taxed at 10% so you only pay $500 in taxes to remove the $5,000 that brought you a $1,100 deduction when it was contributed.
Granted, you will likely need more than $5,000 per year to live in retirement, and you will probably also have other sources of income, but without any earned income, your retirement funds will likely be taxed in lower brackets.
Overall, it will be worth it unless you retire in a much higher tax bracket than when you made your contribution.
You cannot get this benefit from a Roth IRA or Roth 401(k) because contributions and withdrawals in these accounts have no impact on your top tax bracket.
Disadvantage #3: Contribution Limits
Alternatives: 401(k), 403, or 457. You could also just use an after-tax brokerage account, but no tax deductions there ☹.
How to Overcome: Use a “400 level” plan or a mega-backdoor Roth.
I’m going to level with you here.
This isn’t really a disadvantage to me unless you’re comparing IRAs to 401(k)s.
All IRAs, including Roth and Traditional, have maximum contribution limits.
In 2023, IRA contribution limits are $6,500 per year. If you’re 50 or older you can contribute up to $7,500.
I am thankful the government allows us to put anything into an IRA (it’s better than nothing), but IRA limits fall woefully short of the contribution limits available in 401(k), 403, and 457 plans.
These “400-level” plans have tax-advantaged contribution limits of $22,500 or $30,000 if you’re 50 or older. That’s 3 to 4 times as much depending on your age.
Furthermore, any employer contributions made over this amount are still tax-advantaged (depending on your choice of Roth or Traditional).
You can also contribute up to $66,000 (or $73,500 for 50+) on an after-tax basis. I wouldn’t mention this because it doesn’t sound like a tax advantage, but you can then roll this amount into a Roth IRA or 401(k) if your plan allows.
It’s a heck of a lot more space.
Disadvantage #4: Income Restrictions
Alternatives: 401(k), 403, or 457
How to Overcome: Use the Backdoor Roth IRA
If your income is high enough, you won’t be allowed to make a Roth IRA contribution. Here’s a chart to see where you stand:
Filing Status | MAGI | Contribution Limit |
Married Filing Jointly | < $218,000 | $6,500 if under 50; $7,500 if 50 or older |
Between $218k and $228k | A reduced amount | |
> $228,000 | Nothing | |
Single or Head of Household | < $138,000 | $6,500 if under 50; $7,500 if 50 or older |
Between $138k and $153k | A reduced amount | |
> $153,000 | Nothing |
The good news about this problem is it is very easy to sidestep by using the Backdoor Roth IRA method.
To use the backdoor, just make a contribution to an IRA on an after-tax basis for which there are no income restrictions.
Once you’ve funded your after-tax IRA, you can convert it to a Roth IRA.
This is kind of tax loophole, but one the IRS has left open for well over a decade now. If they wanted to close it, they would have by now (not to say they won’t one day).
If you elect to go this route be sure to read up on the pro-rata rule as it could trigger a significant tax problem for you if you.
Also, if your after-tax IRA realizes any earnings after you open it, but before you convert it to the Roth, you will owe income tax on that portion of the conversion.
To avoid any significant taxes, you could just leave the contribution in cash or another low-interest vehicle until you make the conversion.
Disadvantage #5: Early withdrawal penalties
Alternatives: Taxable accounts or wait until 59.5. Withdraw contributions only.
How to Overcome: Rule 72T, Roth Conversion Ladder
In his infinite wisdom Uncle Sam decided that if we were going to get tax benefits for saving for retirement, there should be a deterrent for trying to remove that money prior to reaching retirement age.
Therefore, if you remove earnings from a Roth IRA before the year in which you turn 59.5, you will owe a 10% penalty on your withdrawal.
This is also true for Roth 401(k)s.
That’s not all. If you remove ANY portion of a Traditional IRA, 401(k), 403, or 457 before 59.5, it is subject to income tax and a 10% penalty.
Hopefully, you noticed the distinction between Roth earnings and the entirety of a Traditional balance. I’m pointing this out because you can withdraw any of your contributions to a Roth at any time, tax and penalty free.
But back to the disadvantages of a Roth.
There are a couple of heady techniques to get around this age restriction.
The first is through Substantially Equal Periodic Payments (a.k.a. SEPP, a.k.a. Rule 72T).
The gist of SEPP is once you agree to make equal annual withdrawals from your account for at least five years or until you turn 59.5, whichever occurs later, you can access your Roth dollars without the penalty.
This is not a simple plan to set up and execute. If you go this route, you should get professional help because a screw-up here would be very costly.
The other option, and the one I’d recommend, is a Roth conversion ladder.
A Roth conversion ladder works by converting Traditional IRA savings to a Roth IRA. This will trigger an income tax liability.
After the conversion sits for five years, you can remove the converted portion because the IRS will treat it like a contribution for tax purposes.
This is much easier to pull off than the SEPP, but it does require one to plan about 5 years in advance.
For more on tapping retirement funds before 59.5, read our post about tapping retirement funds before age 59.5.
Advantages of Roth IRAs
I shared from the outset that I like Roth IRAs, so I’m going to list some of the advantages here.
In my opinion, when coupled with the techniques to navigate around the drawbacks, the advantages outweigh the disadvantages.
Your decision to use a Roth IRA should be based more on your expected tax situation now versus when you retire.
Without further ado, here are some advantages of Roth IRAs:
- Tax-free withdrawals
- Access to contributions without penalty
- No Required Minimum Distributions
- Tax diversification in retirement
- Can be used to pay for college
- Heirs inherit Roth IRA completely tax free
- More flexibility in selecting investment options than in a “400 level” plan.
